Head – Research and Development,
National Bulk Handling Corporation Private Limited

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Tuesday, 31 January 2017

Commodity Options in Indian Market Scenario

Currently in Indian market, the futures trade has been functioning
successfully for the last 14 years. It has been increasingly supported by the
participation of traders and merchants and few of the large and medium farmers.
Involvement of small and marginal farmers, who comprises of about 78 per cent
of the farming community, is still not so acclimatized with the futures
trading. Still a lot of effort is needed in this direction. With every passage
of time the commodity futures trade have evolved with increased strength and
transparency.

The introduction of commodity options trade as a new instrument is
likely to enhance the participation base as it requires lesser exposure capital
thereby reducing the enormity of loss. In simple terms, in a futures contract,
both participants in the contract are obliged to buy (or sell) the underlying
asset at the specified price on settlement day. As a result, both buyers and
sellers of futures contracts face the same amount of risk. On the other hand,
the option contract buyer has the right but not the obligation to buy (or sell)
the underlying asset. Hence the term "option" and this option come at
a price in the form of a premium (more specifically, the time value of the premium).
With this "option", the option buyer's risk is limited to the premium
paid but his potential profit is unlimited. Sellers of options take on an
additional volatility risk in exchange for the premium. However, their
potential profit is then capped while their potential losses have no limit.
Hence, this premium can be high if the underlying asset is perceived to be very
volatile. The other major difference is that Options can be exercised at any
time before they expire while a futures contract only allows the trading of the
underlying asset on the date specified in the contract. In futures, the
performance of the contract is done only at the future specified date, but in
the case of options, the performance of the contract can be done at any time
before the expiry of the agreed date. Apart from the commission paid, futures
do not require advance payment, but options require the payment of premium. In
futures, a person can earn/incur an unlimited amount of profit or loss, whereas
in options the profits are unlimited, but the losses are up to a certain level.

The very motive of starting the Commodity futures was to facilitate
efficient price risk management and price discovery in a fair, transparent and
orderly manner. The futures market was to help Indian farmers to hedge their
produce against potential risks arising out of price movements in spot markets
so that they can get guaranteed price for their produce in the future. But, in spite
of 14 years of futures trading through Commodity Exchanges, majority of the farming
community is till away from participating on the platform either due to lack of
awareness or due to complexity of the trading process. Currently, the futures
markets continue to be dominated by speculators and non-commercial players who
frequently indulge in price rigging and other market abusive practices with
impunity.

I feel that the desired penetration level has not been achieved owing
to lack of liquidity and existence of fear factor in the minds of small and
marginal farmers who are still depended on the whole sellers and local
aggregators. According to market estimates, not even 2000 farmers in India are
directly trading on commodity futures exchanges. Even the participation of
farmers marketing cooperative bodies (such as NAFED, HAFED and Farmers
Producers Group) is very limited due to lack of adequate knowledge of the
functioning of futures market. Such bodies can act as aggregators and hedge
positions in futures exchanges on the behalf of their farmers. Thus with such
level of penetration in the market, we can apprehend that futures have failed
to achieve their avowed objectives of price discovery and price risk management
especially for small and marginal farmers (owning less than 2 hectares of
land).

In the Indian Scenario where an average Indian farmer lacks a basic
understanding of what is involved in futures trading. The options trading are
even more difficult to comprehend as it adds yet another layer of complexity on
what is already a very complex trading instrument. In the same vein, small
enterprises lack the resources and capacities to trade actively in derivatives
contracts for hedging purposes. Even experienced traders struggle to understand
the risks involved in trading both futures and options contracts. Moreover the
bulk of trading in the Indian commodity futures market is carried out by
speculators and non-commercial traders who attempt to profit from buying and
selling futures contracts by anticipating future price movements but have no
intention of actually owning the physical commodity, while the participation of
hedgers is almost negligible. Time to time the commodity exchanges are
conducting short duration training workshops for small stakeholders but such
workshops are inadequate to impart information and insights on the complexities
of derivatives trading.

Having said all about the complexity of the futures and options trade,
the introduction of Option in the Commodities trade is still a very welcome
step, but the quantum of challenges to implement it is enormous. The major
challenges could be enlisted as:

·Lack of awareness about the options

·Majority of actual participants (Farmers,
Producer’s Organization, Government entities & banks) are still not clear
on the process of how it could be applied on the agricultural products.

· Liquidity
is still lacking in most of the agricultural products being traded on exchanges